Eager to deploy their funds, private equity firms are investing in restaurants and retailers. The way they approach these deals is changing, however. PE firms are increasingly focused on lease obligations as they look to maximize their investments.
“When deciding whether to invest, private equity firms are beginning to place a heightened emphasis on the lease cost, lease term and remodel status of the assets they are acquiring, as opposed to more traditional factors such as location or operational success,” says Tom Mullaney, a principal with Huntley, Mullaney, Spargo & Sullivan Inc., a lease and debt restructuring firm whose clients include numerous private equity firms.
Mullaney attributes the shift to competitive pressure. “The world is awash in capital, and when that happens, the price of real assets gets bid up to high levels, and buyers want to make sure they’ve made a good investment,” he explains. “If they can improve profitability, the effective purchase price isn’t quite so dramatic, so they’re going after every single line item.”
Largest off-balance sheet liability
Historically, private equity firms would focus their cost cutting on labor expenses or the cost of goods. They didn’t really focus on lease obligations, especially occupancy costs. But that’s changed.
“With lease obligations typically being the largest ‘off-balance sheet’ liability, and in many cases in an amount even greater than loan liabilities, most private equity players have realized it’s important to get it right,” Mullaney notes. “They increasingly have a laser-like focus on occupancy costs. That’s not something we saw five years ago.”
According to Mullaney, the biggest concern for private equity firms is overpaying for an acquisition. By analyzing the lease obligations, the buyers may find reasons for to discount the deal or, alternatively, raise their offer.
For example, Mullaney’s firm helped a leading West Coast private equity firm analyze a 1,000- unit chain and uncovered some hidden value that enabled the firm to increase its bid for the target company with confidence that it wasn’t overpaying.
Private equity firms look at real estate differently than retailers or restaurants, according to Mark Dufton, CEO of DJM Real Estate. Moreover, he says they’re far more metric-driven than they have been in the past when it comes to acquisitions.
“They’re benchmarking against other retailers and restaurant chains,” he notes. “They’re looking at occupancy costs and lease renewal programs holistically and then strategizing on a store-by-store basis, deciding whether a lease obligation should be renewed, restructured or sold off.”
Mullaney says private equity firms are no longer waiting until after an acquisition to start thinking about maximizing the real estate value. He points to Food Management Partners’ recent acquisition of Catalina Restaurant Group Inc., parent to the Coco’s Bakery Restaurant and Carrows Restaurants chains.
“FMP did its due diligence, and on the day they signed the deal, the firm closed the doors of 75 restaurants,” notes Mullaney. “Private equity firms are leaving no stone unturned in trying to improve profitability.”
And it’s not just private equity firms that are scrutinizing the real estate as part of a potential M&A. Many retailers and restaurants are doing their own analysis to increase their value to a buyer.
“If you have a store that is losing $100,000, and there’s a 7x multiple on that EBITDA, that translates into $700,000 in lost value for that store,” Dufton notes. “But if you could exit that lease for $250,000, there’s a real value-add for the seller.”